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Major Negative Market Shift as Structural Issues Impact Cyclical

[Note to editors: I am re-submitting this Instablog with minor revisions, it was originally submitted over 24 hours ago Thurs morning, I believe it still accurately describes the market Friday.--jf]

A big negative shift in market psychology seems to be happening, it is very noticeable Thurs morning, after Cisco reported “better than expected” earnings Wed afternoon, yet tech stocks and the overall market are down about 2% after the first two hours of trading Thurs on other news involving U.S. employment and European debt issues. (This shift is also very clear in commodities, with the price of "Dr. Copper" breaking $3 Wed.)
 
This is a major negative shift in market psychology. The market is shifting its focus from a “cyclical recovery,” however anemic by historical standards, with many claiming it's only a statistical recovery based on very high actual unemployment, to what some like to call the long-term “structural headwinds.”
 
SPX is at 1074 as I write this at 11:27 am EST Thurs, just above its intraday low near 1070 on Jan 29.  How the market closes Thurs, and its reaction to the very important employment report Fri morning will give a clearer indication of how close the post-Mar 2009 rally is to the first chance of a major decline
 
There is of course only one economic reality, but investors compartmentalize it to make it easier to deal with. e.g in terms of cyclical vs structural issues. Up until now, the market had a huge post-Mar 9 rally mainly by focusing on a steady stream of heavily gamed “better than expected” (NYSE:BTE) economic and earnings cyclical reports, helped in large part by the fact that expectations were so low and market psychology so pessimistic.
 
Very quickly in 2010 this Wall Street BTE game has stopped. Fourth-quarter earnings reports are still BTE, but now stocks and the market go down on the news. That means the market is looking out further, to the “structural headwinds,” which all of a sudden seem to loom a lot larger, even though they were always there. The structural is now becoming the cyclical, so to speak.

I had some inkling of the current decline, starting with my Instablog election night Jan 19 "Key Decision Point Imminent," followed by my Jan 23 article (Jan 21 Instablog), "Emerging Markets Leading Global Markets Down, as They DId Going Up," six follow-up articles to that, and about 80 Instablogs on the market in real-time as I was tracking the course of the correction. 

Nevertheless the accelerating speed of the decline was still somewhat surprising, especially for Wall Street strategists, whose main bullish arguments are Fed super-easy money, their usually most reliable trump card, along with undeniably increasing corporate profits and perhaps average valuations,

Some bullish market watchers were expecting a sharp decline later in the year around Sep-Oct (for among other reasons, the second year of the four-year election cycle that also end in 0 tend to be quite poor). One issue for bulls is if the market decline should go much further, then how much unexpended ammo does the Fed and Treasury still have?

What are those structural headwinds I mentioned above? Among them, unemployment, debt, deflation and inflation. The first is very high and very well known. 

As for debt, the market, media, and ironically a combination of Wall Street, fiscal conservatives and understandably angry “populists” are all mainly focused on government debt

Iironic because the increase in government debt has been greatly exacerbated by the collapse of tax revenues from the economic decline caused by Wall Street's crisis, most especially impacting the state and local level), to a lesser extent household debt, and thus still largely ignoring the huge multi-decade increase in financial sector debt.

I.e. the basic cause of Wall Street's crisis was huge leverage of very risky investments with very short-term financing.  For the huge increase in financial sector debt the past three decades, see the charts below that I’ve shown once before, since they go all the way back to 1870 and 1929, you have to pause to let the historical enormity of the debt trends they depict to really sink in. 

Btw, note well the relative size and growth of financial sector to government debt over the past few decades, and also in which decades government debt as a percent of GDP actually grew, they're not what most people think. 
 
Huge amounts of bandwidth (no longer ink) have been spilled arguing in online venues about deflation vs inflation. I don’t get into that discussion, because as I see it, there is debt and wage deflation in the U.S. and Europe, along with some asset inflation, deliberately in government bonds due to Fed policies, and incipient inflation in property, especially, and also goods and services in emerging markets. 

Extremely easy Fed money to counteract debt deflation in the U.S. is spilling over into especially property price inflation in China and elsewhere, through China’s peg to the dollar.
 
Another common way of talking about the market psychology shift underway, I did it myself in my 2009 articles, is whether the economy can now go from the initial recovery phase, which was heavily based on Fed easy money and government stimulus, and characterized in 4Q by a big boost to GDP from a sharp decline in the rate of inventory disaccumulation (inventories actually declined), to a more sustainable expansion in “final demand,” especially business and residential investment and consumer durables, especially autos.
 
In Cisco’s report, the biggest geographic segment, U.S. and Canada, 54% of rev, was up 12%, backing that out, everywhere else was only up 3%. U.S. service provider orders were up in the low twenties percent. 
 
The U.S. economic recovery is not going to be sustainable based on carrier capex for the insatiable bandwidth demands of smartphone users. Nor is the rest of the world going to continue to finance U.S. consumers playing with their iPhones all day. That is just not politically feasible any more in China and in other U.S. creditors. 
 
The U.S. financial/consumer fantasy world ended during the financial crisis when the “Wizard of Oz” curtain was torn away, finally, regarding the supposedly world-class U.S. financial markets. That fantasy world is not coming back.  That's what the markets are finally starting to come to grips with this Thurs morning.

How to create jobs in America is the big issue.  Government doesn't have the financial and other resources to do so.  Big corporate America does, with its strong cash flows and balance sheets (profits margins are above historical average). 

But as long as big corporate America feels Wall Street will punish their stock prices, hence CEO stock options, by increasing operating expenses by hiring, and as long as banks won't lend to small businesses, job growth is going to be slow.  I.e. a financial system definitively proven to be dysfunctional during the Wall Street crisis is now greatly hampering employment growth.

I increasingly believe that corporate America will only slowly deploy its cash flows in new large expansion programs unless the tight link with Wall Street, via CEO options, is modified.  Through that link Wall Street has strong influence over a relatively healthy big corporate sector, with its entrepreneurial, technical and other resources needed for business expansion.

That Wall Street "shareholder value" solution to the so-called "agency" problem of corporate governance doesn't seem to work, have you noticed that ever since it became popular about thirty years ago (after Michael Jensen's 1976 article), the life of the average American employee/consumer hasn't been the same.

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Source:  Hoisington “Quarterly Review and Outlook Fourth Quarter 2009”



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